The Federal Reserve raising interest rates for the first time in seven years in Dec 2015 generated optimism about the prospects of the U.S. insurance industry, as it is one of the very few to thrive in a rising interest rate environment. A rising rate environment typically benefits insurers as their investment strategies are liability-driven.
However, the recent questions surrounding how far and how fast the Fed will hike rates, following its dovish stance so far this year, are making it difficult for the industry to predict benefits. Particularly, the near-term impact of the only hike so far – which was only a quarter-percentage point – on the insurance sector will be limited. It is actually not enough for insurers to be confident of pricing changes.
On the other hand, many insurers have changed their asset allocation strategies in an effort to minimize the impact of the prolonged low rate environment on their business. Moving beyond their traditional holdings, they choose to invest in illiquid assets for increased returns. As a result, they are not prepared to reap the benefits of rising rates.
Although the only rate hike (so far) doesn’t bring much immediate relief for insurers, the Fed will hike rates further, either in predictable fashion or not. And a rising rate environment will surely brace insurers’ business sooner or later.
But the business dynamics of insurers are not that simple, and the relationship of profit with the interest rate is not direct either.
In particular, Property & Casualty (P&C) insurance, which is not very sensitive to the interest rate environment, holds a significant amount of bonds, which would fall in value with interest rates rising steadily (which is very unlikely, though). This will lead to capital volatility in the industry.
However, a rising rate environment would keep alleviating the pressure on P&C insurers’ investment income, and thus their earnings. Moreover, a higher rate environment would make the pricing environment more competitive, further supporting carriers to grow.
Life insurers, however, depend heavily on investment income, so they will benefit more from a rising rate environment. There will be relief from operating pressures resulting from tight credit spreads that the low-rate environment has exerted for so long. However, the benefit is expected to be modest as life insurers have significantly reduced their interest-sensitive product lines in the prolonged low-rate environment.
No matter how the changing interest rate environment impacts insurers, mild catastrophe losses and continued influx of capital are expected to keep most lines of P&C insurance favorable for buyers. Yet evolving threats such as cyber-attacks and a persistently soft market pose challenges for the carriers.
On the other hand, containment of underwriting expenses and a modest increase in premiums are shoring up the prospects of life insurers.
With glaring dissimilarity in business dynamics, it makes better sense to look at the prospects of these two key segments of the U.S. insurance space separately (read our subsequent posts for a detailed insight).
Here is how the overall insurance market looks:
While continued economic uncertainty across the globe is not leaving the U.S. totally unscathed, domestic economic progress makes the backdrop stronger for the country’s insurers. Particularly, given the possibility of the interest rates raising at least twice this year, insurers might see some improvement in their rate-sensitive business.
Moreover, a strong liquidity profile by virtue of continued capital inflow into the industry, ample capacity, conservative product design and evolving coverage will not only limit any downside but will also keep the growth trend alive. Also, the ongoing reserve development will continue to support insurers’ financials.
Increasing insurance literacy through initiatives like The Insurance Consumer Bill of Rights should help the industry witness rising demand for products. Increasing demand from economically recuperating American households should eventually place insurers in a favorable pricing cycle, too.
Further, recovery in underwriting and a lower combined ratio for P&C insurers are expected to continue if the trend of modest catastrophe losses prevails. Then again, lower catastrophe losses indicate lower premium rates as well.
Moreover, heightened competition might curb insurers’ profitability in the quarters ahead. But the rapid influx of alternative capital will keep the prices down and expedite M&A activities.
Regulation Yet To Be Effective
Apparently, a safe and sleepy business nature keeps U.S. insurers out of federal regulations, which could have marred business expansion. But the industry has yet to be strongly braced by the advantages of operating under state-run regulations. Instead, decentralized regulation and consumer protection make the industry susceptible to insolvency.
Now, the changing nature of business -- more like banks in terms of liabilities -- perhaps calls for federal oversight. Though the necessity for a regulatory revamp has been strongly felt after banks witnessed success, this would deliver another blow to the insurance industry.
A provision of the 2010 Dodd-Frank Act requires setting minimum capital and leverage standards on insurance companies, but these have yet to be implemented by U.S. lawmakers, who are considering the distinct business fundamentals different from banks. But the industry, which is increasingly contributing to GDP, has scant chance of being relieved of Federal Reserve control for very long.
Zacks Industry Rank
Within the Zacks Industry classification, insurers are broadly grouped in the Finance sector (one of the 16 Zacks sectors) and are further sub-divided into five industries at the expanded (aka "X") level: P&C, Multiline, Accident & Health, Life and Brokers. The level of sensitivity and exposure to different stages of the economic cycle vary for each industry.
We rank 265 X industries in the 16 Zacks sectors based on the earnings outlook and fundamental strength of the constituent companies in each industry.
We put our X industries into two groups: the top half (industries with the best average Zacks Rank) and the bottom half (the industries with the worst average Zacks Rank). Over the last 10 years, using a one week rebalance, the top half beat the bottom half by a factor of more than 2 to 1. (To learn more visit: About Zacks Industry Rank)
The Zacks Industry Rank is #9 for Accident & Health, #35 for Brokers, #113 for P&C, #180 for Life and #195 for Multiline.
As of April 27, 54.5% S&P 500 companies in the broader Finance sector, of which the Insurance industry is a medium level (or M-level) component, reported first-quarter 2016 results. The earnings beat ratio (percentage of companies coming out with positive surprises) is 64.6%, while the revenue beat ratio came in at 56.3%.
The sector is expected to witness year-over-year earnings decline of 2.4% compared with a 0.5% increase recorded in the prior quarter. Revenues are however expected to show a year-over-year improvement of 2.1% compared with the prior quarter’s growth of 2.7%.
For a detailed look at the earnings trend for this sector and others, please read our latest Earnings Trends report.
Looking at the broader trends, the overall health of the industry appears to be improving despite the emergence of new issues. And learning from past experience, insurers are resorting to expense-saving measures to tread water.
If insurers manage to overcome the short-term resistance that may be holding back premium rate increases, they should ultimately witness margin expansion. Also, in the absence of federal regulation, insurers can take on new challenges with the ample capital that they now have.
How to Play the Insurance Sector
As you can see, apart from the expected benefits from a rising rate environment sooner or later, there are plenty of other reasons to be optimistic about the industry’s prospects. So it would be prudent to pick a few insurance stocks that might outperform the markets in the near term.
We highly recommend stocks with a Zacks Rank #1 (Strong Buy) such as Amerisafe, Inc. (AMSF - Free Report) , eHealth, Inc. (EHTH - Free Report) and Hallmark Financial Services Inc. (HALL - Free Report) .
However, we suggest staying away from or getting rid of Zacks Rank #5 (Strong Sell) stocks such as United Insurance Holdings Corp. (UIHC - Free Report) and Universal American Corp (UAM).
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